What Are Municipal Bonds and How Do These Tax-Free Securities Work?

Like the idea of tax-advantaged investing, but already maxed out your retirement account contributions for the year? Or do you want to reduce risk in your retirement portfolio without completely stripping your returns?

Consider municipal bonds. 

They come with unique tax advantages that can offset their modest returns, all with relatively low risk.

What Are Municipal Bonds?

Municipal bonds are debt instruments — loans — borrowed by city and local governments. These governments typically use these “munis” to raise money for public projects such as schools, streets and highways, bridges, hospitals, public housing, and utilities.

Like other bonds, you buy them and then receive interest for the life of the bond. That term could be as short as a year or two, or measured in decades. Municipal bonds pay interest at either a fixed or variable rate, depending on the terms of the bond. 

When they reach their maturity date at the end of the term, you receive your original principal back. 

Types of Municipal Bonds

City governments issue municipal bonds as one of three types of debt obligation:

• General Obligation Bonds repay based on the “full faith and credit of the issuer” and are considered the most secure type of bond, paying out the lowest interest rate. In other words, as long as the local government is solvent, they’re obligated to pay you back.
• Revenue Bonds repay from a specified future stream of income, such as a utility or payments from customers or tenants. If the local government fails to collect that specific income, they could theoretically default and opt not to pay you back. 
• Assessment Bonds obligate repayment from property tax assessment within the municipality. Likewise, the local government could default if they fail to raise enough revenue from property taxes.

Returns vary between municipalities, as does risk. As you can imagine, some cities and municipalities are far better managed than others. The more fiscally responsible the local government, with less debt on their balance sheets, the lower the risk in lending them money. And, of course, they can pay lower interest accordingly. 

Remember when Detroit declared bankruptcy back in 2013? Then you get what can go wrong lending money to financially strapped or poorly governed cities. 

In short, do your homework before buying municipal bonds. Check the credit rating, as assessed by a neutral third party, showcasing the credit quality and credit risk of each municipal bond. Municipal bond funds such as exchange-traded funds (ETFs) and mutual funds can handle some of this research for you and help you diversify across many municipalities, reducing your exposure to any one rotten apple.

Tax Treatment of Municipal Bonds

The federal government doesn’t charge income taxes on municipal bond interest payments. Often state and local governments don’t charge taxes on them either, particularly in the state where the bonds were issued.

That makes municipal bond interest income (also called coupon payments) either partially or completely tax-free. 

Still, some states and cities do charge income taxes on the interest. Check your own state and local tax rules, and especially check if they charge state income tax on munis issued in other states. 

Capital Gains on Municipal Bonds

Despite the interest being tax-free, you may still owe capital gains tax on municipal bonds. 

If you buy a muni bond on the secondary market at a discount, the IRS charges you for capital gains when you either sell it for a profit or it reaches maturity. Unlike most other capital gains, these gains can’t be offset with losses. 

Bondholder beware. 

The “De Minimis” Tax Rule

As a confusing and technical tax rule, in some cases you can owe regular income taxes on your gains rather than the lower capital gains tax rate. 

Known as the de minimis tax rule, if you buy a municipal bond at a discount equal to or greater than a quarter-point per year until maturity, the IRS taxes you on the gains at your ordinary income tax rate. 

Like I said, confusing and technical. And annoying.

For example, say you buy a municipal bond with a face value of $100 for $99 — a 1% discount. 

If the bond matures in two years, the de minimis rule would trigger, because you bought it at a discount greater than a quarter-point per year. In this example, your discount would be a half-point per year — you bought it 1% discounted, with a remaining term of two years.

However if five years remained, you wouldn’t run afoul of the de minimis rule. Your discount would only come to 0.2% per year, below the 0.25% threshold. 

Taxable Equivalent Yield

To compare apples to apples, you can calculate how the tax benefits improve your returns on muni bonds, compared to taxable bonds. 

Put simply, the taxable equivalent yield indicates the municipal bond’s yield plus the tax benefit received.

For example, due to its tax-exempt status, a municipal bond note yielding 4% may actually have a taxable equivalent yield greater than 6%, depending on your income tax bracket. To calculate the taxable equivalent yield, you need to know your tax rate.

The relationship between municipal bond yields and tax rates can be expressed with the following equation:

r_m = r_c (1 – t)

where:

• r_m = interest rate of municipal bond
• r_c = interest rate of comparable corporate bond
• t = your income tax rate

Not a math whiz? No worries. Use a free taxable equivalent yield calculator to run the numbers based on your income and the bond yields in your portfolio.

If you choose to invest in municipal bonds through an ETF or mutual fund, they include the taxable equivalent yield in the prospectus. In fact, it is often broken down by tax bracket, which makes it easy to see whether tax exempt municipal bonds make sense for you.

How to Buy Municipal Bonds

You can buy municipal bonds through your regular brokerage account, or through an investment advisor. If you like, you can work with specialized bond dealers, or talk to your bank about whether they handle municipal bonds.

Alternatively, you could buy shares in a mutual fund or ETF specializing in muni bonds. These funds offer an easy way to diversify your muni investments.

You may even be able to buy muni bonds directly from the municipal government itself. However buying municipal bonds on the primary market is complicated, and you need an account with a bank bringing the bond issue to market. The retail order period only lasts a few days, so the buying window closes quickly.

Pros and Cons of Municipal Bonds

Like all investments, municipal bonds come with their share of advantages and disadvantages.

Pros of Municipal Bonds

Consider the following reasons to invest in muni bonds as you explore your options.

1. Tax Advantages. As outlined above, you pay no federal income taxes on municipal bond interest. Often you pay no state or local income taxes on it either.
2. No Limit on Purchases. Tax-sheltered retirement accounts put a cap on how much you can contribute each year. But you can buy as many municipal bonds as you want in your taxable brokerage account. 
3. Low Default Risk. From 1970 to 2019, the 10-year cumulative default rate for all rated municipal bonds was just 0.2%, according to T. Rowe Price. Compare that to the corporate bond default rate of 10.2%. 
4. Low Volatility. Municipal bonds also see low price volatility, adding to their safety.
5. Liquidity. You can buy or sell municipal bonds at any time on the secondary market.

Cons of Municipal Bonds

Munis aren’t without their downsides, of course. Make sure you understand the risks and disadvantages before investing.

1. Inflation Risk. When inflation surges, fixed-income assets like bonds offer less value. You get your original principal back at the end of the term, but the greater the inflation over that term, the less your original investment is worth. For example, if you buy a five-year bond paying 2%, and inflation averages 3%, during those five years you effectively lose 1% on your money. 
2. Interest Rate Risk. When interest rates rise, newly issued bonds pay higher interest. That lowers the value of older, lower-paying bonds, so their price drops on the secondary market. 
3. Taxes on Gains. You still have to pay taxes on capital gains on your municipal bonds. And in some cases, you may have to pay taxes at your regular income tax rate if you trip the de minimis tax rule. 
4. Low Default Risk Doesn’t Mean Risk-Free. Don’t assume that municipal bonds carry no risk of default. The higher the yield munis pay, the higher their risk of default.

Final Word

As you approach retirement, you should lower the risk in your investment portfolio. That typically means converting some of your stock investments to bonds.

While municipal bonds pay nowhere near the average historical stock market returns around 10%, the tax advantages can offset the low interest rates. Muni bonds offer the best tax savings to higher income investors. 

For easy diversification, municipal bond investors should consider ETFs or mutual funds specializing in muni bonds.

Balance risk with returns, even in retirement. That means leaving plenty of your money in stocks, and perhaps diversifying into real estate as well. Municipal bonds may deserve a place in your portfolio, particularly for higher earners, but consider speaking with a financial advisor as you set a target asset allocation for your retirement investments.